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Jim Chanos has made a very nice living and a big reputation out of seeing what others overlook, particularly when it comes to overvalued companies. The prominent short seller's big wins include sniffing out problems at Enron, Tyco, and WorldCom in the early 2000s before those companies imploded. Chanos figures that if he and his colleagues get two-thirds of their picks right, they are doing very well. This year, as equity markets have rallied, the two short funds he runs are down slightly, versus an 18% decline through November for short sellers tracked by the Dow Jones Credit Suisse Hedge Fund Index. Chanos, 55 years old, founded his own firm, Kynikos Associates, in 1985 and currently oversees about $6 billion of assets. He remains bearish on China, and more recently has been taking a skeptical view of leveraged natural-gas exploration-and-production companies. Barron's sat down with Chanos recently at his midtown Manhattan office.

Barron's: Let's start with your big-picture view.

Chanos: As we went into 2012, we thought, from an investment point of view, that the U.S. was the best house in a bad neighborhood. Since then, pretty much all of the bad neighborhoods have done well, including the U.S., whereas people were pretty cautious a year ago and were looking at the world as a glass half-empty. They are now pretty ebullient and see the world as a glass half-full. So we are seeing opportunities in names that we had covered earlier this year or in 2011 or 2010. We are seeing lots of new ideas on the short side, both in the U.S. and globally, and generally we have a lot to do. The world has come around to the view that the central banks generally are omnipotent and have solved all the world's problems, but we are a little bit less sanguine on that point of view.

"For every job we add in natural gas, we are losing half a job in coal." -- Jim Chanos
Evan Kafka for Barron's

The central banks, like any committee, may get something right, and they may get something wrong. But they are not right all the time. And investing one's capital on the basis of where central banks are planning their policy moves is a little bit frightening.

Because there is too much liquidity?

Well, liquidity is a double-edged sword. It can raise asset prices. But it can also create overcapacity, overconfidence, and overvaluations. Right now, it is on the road to doing all three.

You mentioned that you are seeing opportunities in names that you covered. What do you mean by that?

There are lots of things that we've actually made a fair amount of money on in 2010 and 2011 that we took off the sheets, but that we are now looking at again, because many of them have doubled and tripled again.

What are some of the common mistakes that you see value investors making?

Value investing is just one tool in an investor's arsenal. All things being equal, one would prefer to buy stocks cheaply than dearly. But I'm afraid that too many value investors stop the process by just looking at valuation and, in effect, looking at the rear-view and side mirrors, not through the windshield. You have to be very careful, because we looked at our returns over the past 10 years, and, particularly since the advent of the digital age, some of our very best shorts have been so-called value stocks. One of the differences in the value game now versus, say, 15 or 20 years ago, is that declining businesses, while they often throw off cash early in their decline, find that cash flow actually reaches a tipping point and goes negative much faster than it used to.

So, in the past, value investors looked at declining free cash flows and put some discount rate on that. And then they got a value, and then they would say, "Gee, there is the possibility of a call-option value of the business inherent to all its other opportunities. So, if I can buy it at some discount to that present value, I'm in good shape." But we've seen time and time again where the cash flows do not gradually decline. Nor do managements seem very willing to pay out cash flows when they are in a declining business. They often use them to make acquisitions, trying to save the business on a Hail Mary basis. The advent of digitization in lots of businesses also means that the timing gets compressed, meaning that you need to move quickly or you are roadkill on the digital highway. That's true whether you look at companies like
Eastman Kodak
[ticker: EKDKQ], or Blockbuster, or the newspapers. Value investors have been drawn to these companies like moths to the flame, only to find out that the business has declined a lot faster than they thought and that the valuation cushion proved to be anything but.

Let's turn to China, on which you have been bearish since late 2009.

We haven't changed our thinking much at all on China. Our view is twofold. There is a credit bubble going on in China, and they have an unsustainable economic model. That yields you all kinds of interesting possible ideas, whether it is in the property market, the steel sector, or in all kinds of areas where they are just simply building more of it, even though there are no economic returns. Take a look at China's steel sector; it will be unprofitable in 2012, and yet they are adding more and more capacity. So, because China is obsessed with GDP [gross domestic product], and Western investors and observers are also obsessed with China's growth, China has an investment-driven model where they simply want to produce GDP growth. So they stick a shovel in the ground and build another bridge or highway. They can continue showing GDP growth, as long as there is credit to support that investment. The problem is that most of these investments, at this point, do not generate an economic return and haven't for a while. So you have the dichotomy of a country growing its GDP but destroying wealth. I view it as a stock that's rapidly growing, but whose earnings are below its cost of capital. Any finance professor would tell you that's a company that is liquidating and going to run into the wall. That's what China is doing. But it can go on for a while.

What are some of the companies in China that you are shorting?

We would be short pretty much all of the large banks. We have talked about
Agricultural Bank of China601288.sh -0.17825311942959002%Agricultural Bank of China Ltd. ADRU.S.: OTCUSD11.2
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265836More quote details and news »601288.shinYour ValueYour ChangeShort position
[601288.China] publicly, but I would stay clear of all of them. They are all going to have issues. I would also avoid the property developers, the Chinese steel sector, and the Chinese cement sector.

What are people missing about the U.S. shale explosion?

Well, it is good in some ways. It is good for the U.S. economy. It is good for employment. But it is deflationary for lots of energy assets, not least of which is natural gas itself and similar energy-related assets like coal. So everybody is drilling, many people because they have to, due to the terms of their leases. And even at prices that, heretofore, a lot of people felt were uneconomical—$3 per Mcf [1,000 cubic feet]—they are still drilling away. So the law of unintended consequences has worked both ways. It has been a boon for manufacturing in the U.S. It has been a boon for certain regional employment. But it has been deflationary for the leveraged natural-gas E&P companies that actually bought acreage when gas was $8 to $10 per Mcf, and they are now facing a reality of $3 to $4. And it probably has been quite deflationary, on the margin, for the thermal-coal companies that really compete now with natural gas. That was a bit of an unintended consequence of the fracking boom. So while we talk about the environmental efficacy of fracking, we see a benefit that less coal is being burned. But on the other hand, for every job that we add in natural gas in the U.S., we are maybe losing half a job in the coal industry.

Which companies are most vulnerable?

Chanos's Pans

Recent

Company

Ticker

Price

Agricultural Bank of China

ACGBY

$12.49

Vale

VALE

20.46

Petrobras

PBR

20.58

Leveraged natural-gas E&P companies

Source: Thomson Reuters

The vulnerability is certainly in the thermal-coal producers. They have issues with the EPA [U.S. Environmental Protection Agency] regulations, as well as the economics. But I would avoid the leveraged natural-gas companies like the plague. The fellows who leveraged up to buy lots of properties five, six, or seven years ago are now all trying to sell them. So, they were buyers at $8 to $10 [per Mcf], and they are sellers at $3 to $4. And the problem with a number of these companies is that because of the contractual nature of their leases, which a lot of people didn't understand, they are obligated to keep drilling. So their costs don't seem to decline as fast as their revenues do. But because they use oxymoronic at full-cost accounting, which let's you capitalize everything on your P&L [profit-and-loss statement], the earnings statements don't look so bad. But the cash-flow statements are a disaster.

So, when they capitalize those assets, they go on the balance sheet as an asset?

Exactly. It is capitalized, and the companies take these big-bath write-offs later. Of course, it ignores the write-offs, but what they really ought to be doing is depreciate these assets all along.

But it makes a company's P&L look better initially?

It makes the earnings look better until you take the big bath, which, of course, everybody disregards. But take a look at
BHP Billiton
[BHP], which bought properties a year and a half ago from
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5760069083.07876
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4.041570438799076% Rev. per Employee
2986730More quote details and news »CHKinYour ValueYour ChangeShort position
[CHK]. BHP already wrote those off, and they wrote them off by half. So you have a big operator selling to a well-heeled natural-resource company that comes in and realizes, "Gee, these leases aren't worth what we thought they were." So that whole sector is going to be problematic and full of minefields for the next year.

Can you name some of those companies?

Let's just say that if you look at the leveraged guys who were buying lots of properties five years ago that are trying to sell them aggressively now, it is a pretty good bet we're short them.

You've also been shorting two Brazilian companies,
Vale
[VALE], the world's largest producer of iron ore, and
Petrobras
[PBR], the energy outfit. What's your thesis?

With Vale, it is just a giant bet that the construction bubble goes on forever in China.

The stock hasn't done well this year, down about 5%.

It has been a good performer on the short side. You have to understand that for a lot of the mining companies in Brazil and Australia, the model has changed. In the past, the governments, to develop jobs, would work hand-in-hand with these companies to build port facilities, railheads, and other infrastructure to help them export this stuff. Now it is almost the opposite. Not only do the companies have to pay for all this stuff themselves, but the government adds extra taxes and sees it as sort of a patrimony. So the business model has changed dramatically for a lot of the extraction-type companies, Vale being one of them.

What about Petrobras, whose shares have fallen about 17% this year?

We call it Brazil's ATM because you have a state energy giant that cannot charge full-market prices downstream for its gasoline or its diesel fuel, which subsidize the consumers of Brazil. And yet Petrobras has to incur all of the increasingly expensive costs of finding oil offshore. In the past 12 months, Petrobras had cash flow of roughly $30 billion, capex [capital expenditures] of roughly $40 billion, and declining revenue and production. It is not a good business for outside shareholders. It is, in effect, a national utility where the outside investors are being asked to finance it.

Could you talk about a mistake you made and what you learned from it?

At the dawn of the digital age, when we shorted
AOL
[AOL] back in 1996, it basically went up eightfold on us. Although it didn't put us out of business, it certainly caught our attention. We learned about timing. Interestingly, as
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1.5901862789641072% Rev. per Employee
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[TWX] found out later, the accounting issues were actually very real. Their churn was actually much higher than they were letting on. But we also had a healthy regard for the ability of corporations to be gullible and to fall for the same hot trends as everyone else. You can never get the timing exactly right, even if you are right on the fundamentals, ultimately. But on the other hand, you can be very, very right and still lose lots of money, so you have to construct your portfolio accordingly and never let one position ever be too large. That was a good lesson, and it probably saved us a lot of money.